Naked Capitalism on the Bank Takeover

Simon Johnson wrote a remarkably blunt article for the Atlantic in May 2009 titled The Quiet Coup. In case you managed to miss it, it remains critically important reading. He provided an update of sorts in a New York Times column today.

Johnson, a former chief economist to the IMF, described how the financial services industry had effectively engaged in a banana-republic-style takeover of government. And the IMF’s experience of countries that had suffered economics crises due to mismanagement of the ruling oligarchs was that there was one condition that was key to whether reforms stuck: at least some of the ruling group needed to break ranks and be willing to cede power. Clearly, nothing of the kind has happened here.

Johnson depicted how the banking sector came to be bloated relative to the economy as a whole:

…elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them….

The financial industry has not always enjoyed such favored treatment. But for the past 25 years or so, finance has boomed, becoming ever more powerful. The boom began with the Reagan years, and it only gained strength with the deregulatory policies of the Clinton and George W. Bush administrations. Several other factors helped fuel the financial industry’s ascent. Paul Volcker’s monetary policy in the 1980s, and the increased volatility in interest rates that accompanied it, made bond trading much more lucrative. The invention of securitization, interest-rate swaps, and credit-default swaps greatly increased the volume of transactions that bankers could make money on. And an aging and increasingly wealthy population invested more and more money in securities, helped by the invention of the IRA and the 401(k) plan. Together, these developments vastly increased the profit opportunities in financial services.

Not surprisingly, Wall Street ran with these opportunities. From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.

In the New York Times, Johnson again looks at this topic and has to reframe it only a bit in the light of the intervening years: this isn’t just a US problem, it’s a “rich country” problem. This blog stressed, early in the crisis, how the Japanese were uncharacteristically strident in telling the US that its biggest single mistake in managing its real estate/lending crisis was its failure to clean up bank balance sheets and reform them. That advice was simply ignored.

And Johnson posits that it’s the economic heft that the financial sector comes to assume in big economies that enables them to block reforms. From the New York Times today:

When middle-income “emerging markets” encounter a financial crisis because of dysfunctional incentives in the banking system, the obvious reaction is to adopt reforms that make banks safer…Prominent people in other sectors are deeply annoyed at the collateral damage caused by excessive risk-taking by bankers.

And in most middle-income countries, the financial sector comprises at most a few percentage points of gross domestic product…

In contrast, in a country like the United States or Britain, the financial sector is much larger as a percent of G.D.P. – from 7 to 9 percent, depending on how exactly you measure it. This is a direct result of having accumulated more financial assets – a direct result of prosperity and the reasonable desire to save for retirement.

In addition, because rich countries are able to issue a great deal of government debt in the short-term and have central banks with credibility in limiting inflation, they are able to provide very large amounts of support, direct and indirect, that prevent prominent financial companies from collapsing.

There is no sector in the modern United States or Britain that is willing to stand up to big banks in the political arena. And top financial-sector executives continue to enjoy such high prestige that they are still called upon to run public finances.

I have one quibble with Johnson: corporate executives in other industries are in cahoots with Wall Street, so they’ve got no reason to gang up on them. Executive pay is now based on stock market returns, and worse, CEOs are increasingly selected based on how investor and media-genic they are, rather than how good they are at running things. And CEOs regularly buy themselves a new lease on life when performance is flagging by doing a big acquisition (Carly Fiorina at HP is a classic example). Moreover, CEOs of mid-sized companies and C level execs of big ones can further enrich themselves by going to private equity firms, another reason to make nice with the financiers.

That means that Johnson’s “rich country problem” isn’t just that of a bigger financial services industry; it’s also in the differences in the nature of the ruling groups. I invite readers to elaborate, but in developing economies, you often see certain families assuming near dynastic standing in public affairs, and economic power concentrated often in family businesses (again dynastic) which often play big roles in key industries and/or control critical resources (large landholders, meaning they control either agricultural resources or extractable commodities). But in more advanced economies, the tribalism is much more along class lines: CEOs of public companies, for instance, arguably have many common interests, and those in many cases compete with, and can even exceed, industry-based allegiances. So while the financial services industry brings this issue of where the loyalties of other power players into focus, the interdependence among members of elite groups looks to be much greater than even the financial services example indicates.

But consider a related question: the health care industry consumes an even bigger share of GDP than financial services, and with the exception of 2009, has also spent the most on lobbying. Now health care doesn’t engage self-destructive excesses that threaten to pull down the economy like finance; one can think of it as a vastly smarter parasite. But I put it to readers to consider whether the keenly sought “bend the cost curve” exercise will do much more than squeeze the weakest players (presumably doctors and small vendors) precisely because no corporate constituency has chosen to question the health care industry’s privileges. In other words, under any pressure, the elites (in particular corporate executives) will band together and if any sacrifices must be made, you can be sure they’ll come from ordinary citizens.